How inflation can deplete net worth over time

In the past couple of years I’ve noticed that every time I head to the supermarket to buy groceries or fill my car up with gas, prices seem to be slowly creeping up.

When I pay my utility bills or cover additional costs for medical care, prices seem to be increasing more and more. The services haven’t improved, the products are no different but the costs seem to be increasing.

The question is, how do we deal with the cost of inflation — we can’t control it and more importantly we can’t avoid it.

By textbook definition, inflation is a rise in the general price level of goods and services in an economy over a period of time.

When the general price level rises, each unit of currency buys fewer goods and services, so it can be said inflation reflects erosion in the purchasing power of money.

The question for the average investor is: ‘How does that affect my investments and what type of rate of return do I require in order to keep ahead of it or outpace it?’ This is an especially important issue for people living on a fixed income, such as retirees.

The impact of inflation on your investments depends on the type of investments you hold. If you invest only in stocks, inflation should not keep you up at night. The greatest impact will be felt through fixed income investments; fixed income recipients will feel the greatest pain because while inflation increases, their income does not, therefore their income will have less value over time.

Currently we have a financial environment that offers low interest rates to invest i.e. Less one percent for a one year deposit; however our rate of inflation is three percent.

After a year, interest is received for the amount of money invested, however the purchasing power for the money that was locked away during that year will have a slightly lesser value than before it was invested.

So how do we try and combat inflation?

If you are looking to invest, you must seek returns/interest rates that pace above inflation.

Be wise when sitting on cash in your savings account. If you are earning 0.25 per cent interest on the money you have in your bank account and the inflation rate is three per cent, then you are losing purchasing power.

If you have a variable rate mortgage, switch to a fixed rate if you can find a rate that is low enough. Look at all your investments and that includes your pension too, making sure your investing for the long term.

Invest in long term capital gains, as short term investments tend to give deceptive results or a sense of making profits when in reality you are not.

The reality is, inflation does exist and how you choose to manage your investments and spend your money is equally as important.